Goodbye to all that tosh about wage/price spirals

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The Independent Online
It is time to call the end of an era. For much of the post-war period, prices chased up wages in a spiral that was capable of turning mild initial inflationary impulses into runaway surges. That era is over. The price-wage spiral has ground to a halt.

Yet only six months ago, the Bank of England was fretting about "second- round effects" - its jargon for the price-wage spiral - following the sharp rise in commodity prices in 1994 and the substantial depreciation of sterling in the first half of 1995. As it conceded in yesterday's Inflation Report, such fears were unwarranted. The price-wage spiral, bane of post- war economic management, has been conspicuous by its absence in the recovery of the 1990s.

The latest snapshot of the labour market from the Central Statistical Office rams home the point. Despite an unexpectedly sharp fall in the jobless count in January, the annual rate of increase in underlying earnings remained stuck at 3.25 per cent in December. What this means is that retail price inflation ran ahead of earnings growth in 1995. As the chart below shows, this is something that has occurred on only two other occasions in the past 15 years, and then only when the economy was in sharp recession.

The Bank may have got it wrong last year about the potential consequences of imported cost pressures, but its misgivings were quite understandable in view of the post-war record. The time-honoured pattern was for an almost automatic pass-through of rising import prices, first to the shops, and then to the shopfloor. A study by the National Institute of Economic and Social Research in 1993 showed that this magnifying process made overseas price pressures and depreciation of sterling the principal cause of inflation in the 1970s and 1980s. Once the price-wage spiral had got under way, inflation could only be brought back under control through the ultimate sanction of a policy-induced recession.

This historical template has been shot to pieces in the recovery of the 1990s.

For one thing, the pass-through from higher import prices to the shops has been largely blocked by fierce competition on the high street. Retailers have had to take higher costs on the nose and the result has been a startling compression in margins. After the experience of 1993, when import prices rose 10 per cent but retail price inflation fell, received wisdom was that this was a one-off. Yet the rise in import prices in 1995 was much the same as in 1993. On a conventional rule of thumb, this in itself should have pushed up retail price inflation by 2.5 per cent. Instead, headline inflation rose by under 1 per cent.

The fact that inflation rose so modestly has played a big part in suppressing a price-wage spiral. The era of the "going rate", when trade unions made it a test of their machismo to match the Ford benchmark deal, may have gone. But for anyone negotiating a pay rise, headline inflation remains the ultimate benchmark. No one readily concedes a cut in their real income.

And yet that is, in effect, what occurred last year as underlying earnings fell behind headline inflation. The development took forecasters by surprise.

In December 1994, the consensus expectation was for a rise in average earnings of 4.5 per cent. Instead, the rise has been 3.3 per cent - just under the rate of inflation, and well under when the effect of rising taxes is taken into account.

The obvious question is whether this docile behaviour will hold in the immediate future. Two threats have been identified. One is a rise in pay settlements. The other is a reassertion of the usual patternwhereby total earnings rise by more than the basic pay negotiated in such settlements.

Pay settlements are monitored closely because they are often a leading indicator of overall earnings. This is because they capture the pay rises for the coming year of the group currently settling. By contrast, earnings represent the pay awards over the past year for all groups in the labour market.

According to the Bank's own employment-weighted index, settlements moved up from 3 per cent in the first half of 1995 to 3.5 per cent in the second half. On the evidence so far for January, they have stayed at 3.5 per cent. A fear now, however, is that the concession of 4 per cent pay awards by the Government for the public sector will act as a magnet for subsequent pay settlements in the private sector.

However, this pre-supposes the continuing power of the "going rate". In today's labour market this has become far less important. If any going rate exercises influence it will be the prospective fall in headline inflation this spring.

A further ground for optimism is that earnings have tended to lead settlements since the early 1980s, rather than the reverse. The reason for this counter- intuitive finding - made by the Bank of England in an earlier Inflation Report - is that total earnings can be adjusted during the year, through bonuses and overtime, to the state of demand. Negotiators then build them into the next pay round.

Underlying earnings fell back in 1995, starting the year at 3.75 per cent and ending it at 3.25 per cent. If earnings do lead settlements, this suggests the recent rise in pay awards may prove the high point of an incoming tide. Some high point, some incoming tide is the only sensible verdict.

The other risk to an otherwise benign outlook for pay is that the usual gap between total earnings and basic pay will reassert itself. At present, this differential, called "wage drift", is negligible. In the past 10 years it ran at 1.7 per cent, so if it were to return, the effect would be considerable.

However, the main reason for the disappearance of wage drift seems to be the rising number of part-timers in the workforce. Since employment started to recover in spring 1993, 60 per cent of the rise in employees has been part-time workers. There has been no let-up in this process, according to the most recent Labour Force Survey. This showed the number of full-time employees falling between the summer and autumn of 1995, while part-timers rose.

The conclusion is that the risks of an old-style escalation in wages seem remote. The price-wage spiral seems to be beaten for the time being.

A new chapter has begun for the economy - one with the potential for a happier ending for long-term inflation and for unemployment. Whether that potential is grasped is another story.